Chap11(Agg Demand II)

7/31/2019 Chap11(Agg Demand II)

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macroeconomicsfifth edition

N. Gregory Mankiw

PowerPoint Slides

by Ron Cronovich

CHAPTER ELEVEN

Aggregate Demand II

macro

2004 Worth Publishers, all rights reserved


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m

CHAPTER 11 Aggregate Demand II slide 1

Context

Chapter 9 introduced the model of aggregatedemand and supply.

Chapter 10 developed the IS-LM model, thebasis of the aggregate demand curve.

In Chapter 11, we will use the IS-LM model to

see how policies and shocks affect incomeand the interest rate in the short run when

prices are fixed derive the aggregate demand curve

explore various explanations for theGreat Depression


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The intersection determines

the unique combination ofY and r

that satisfies equilibrium in both markets.

The LMcurve represents

money market equilibrium.

Equilibrium in the IS-LMModel

The IScurve representsequilibrium in the goods

market.

( ) ( )Y C Y T I r G

( , )M P L r Y IS

Y

rLM

r1

Y1


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Policy analysis with the IS-LMModel

Policymakers can affect

macroeconomic variableswith

fiscal policy: G and/or T

monetary policy: M

We can use the IS-LM

model to analyze the

effects of these policies.

( ) ( )Y C Y T I r G

( , )M P L r Y

IS

Y

rLM

r1

Y1


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causing output &

income to rise.

IS1

An increase in government purchases

1. IScurve shifts right

Y

rLM

r1

Y1

1by

1 MPCG

IS2

Y2

r2

1.2. This raises money

demand, causing theinterest rate to rise

2.

3. which reduces investment,so the final increase in Y

1is smaller than

1 MPCG

3.


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IS1

1.

A tax cut

Y

rLM

r1

Y1

IS2

Y2

r2

Because consumers save

(1MPC) of the tax cut,

the initial boost in

spending is smaller for T

than for an equal G

and the IScurve

shifts by

MPC

1 MPCT

1.

2.

2.so the effects on r and Y

are smaller for a T than

for an equal G.

2.


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2. causing theinterest rate to fall

IS

Monetary Policy: an increase in M

1. M> 0 shiftsthe LMcurve down(or to the right)

Y

r LM1

r1

Y1 Y2

r2

LM2

3. which increases

investment, causingoutput & income torise.


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Interaction betweenmonetary & fiscal policy

Model:monetary & fiscal policy variables

(M, G and T) are exogenous

Real world:

Monetary policymakers may adjust M

in response to changes in fiscal policy,

or vice versa.

Such interaction may alter the impact ofthe original policy change.


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The Feds response to G > 0

Suppose Congress increases G. Possible Fed responses:

1. hold M constant

2. hold r constant

3. hold Y constant

In each case, the effects of the Gare different:


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If Congress raises G,the IS curve shifts

right

IS1

Response 1: hold M constant

Y

rLM1

r1

Y1

IS2

Y2

r2If Fed holds M

constant, then LM

curve doesnt shift.

Results:

2 1Y Y Y

2 1r r r


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right

IS1

Response 2: hold r constant

Y

rLM1

r1

Y1

IS2

Y2

r2To keep r constant,

Fed increases M to

shift LM curve right.

3 1Y Y Y

0r

LM2

Y3

Results:


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right

IS1

Response 3: hold Y constant

Y

rLM1

r1

IS2

Y2

r2To keep Y constant,

Fed reduces M to

shift LM curve left.

0Y

3 1r r r

LM2

Results:

Y1

r3


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Estimates of fiscal policy multipliers

from the DRI macroeconometric model

Assumption aboutmonetary policy

Estimatedvalue ofY/ G

Fed holds nominalinterest rate constant

Fed holds moneysupply constant

1.93

0.60

Estimatedvalue ofY/ T

1.19

0.26


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Shocks in the IS-LMModel

ISshocks: exogenous changes in thedemand for goods & services.

Examples:

stock market boom or crashchange in households wealth C

change in business or consumer

confidence or expectations I and/or C


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EXERCISE:Analyze shocks with the IS-LM model

Use the IS-LMmodel to analyze the effects of1. A boom in the stock market makes

consumers wealthier.

2. After a wave of credit card fraud, consumers

use cash more frequently in transactions.

For each shock,

a. use the IS-LMdiagram to show the effects

of the shock on Y and r.b. determine what happens to C, I, and the

unemployment rate.


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CASE STUDY

The U.S. economic slowdown of 2001~What happened~

1. Real GDP growth rate

1994-2000: 3.9% (average annual)

2001: 0.8% for the year,

March 2001 determined to be the end ofthe longest expansion on record.

2. Unemployment rate

Dec 2000: 3.9%

Dec 2001: 5.8%

The number of unemployed peoplerose by 2.1 million during 2001!


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CASE STUDY

The U.S. economic slowdown of 2001

~Shocks that contributed to the slowdown~1. Falling stock prices

From Aug 2000 to Aug 2001: -25%Week after 9/11: -12%

2. The terrorist attacks on 9/11

increased uncertainty

fall in consumer & business confidence

Both shocks reduced spending andshifted the IS curve left.


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CASE STUDY

The U.S. economic slowdown of 2001

~The policy response~1. Fiscal policy large long-term tax cut,

immediate $300 rebate checks

spending increases:aid to New York City & the airline industry,war on terrorism

2. Monetary policy

Fed lowered its Fed Funds rate target11 times during 2001, from 6.5% to 1.75%

Money growth increased, interest rates fell


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CASE STUDY

The U.S. economic slowdown of 2001~The recovery~

The recession officially ended in November2001.

Real GDP recovered, growing2.3% in 2002 and 4.4% in 2003.

The unemployment rate lagged:5.8% in 2002, 6.0% in 2003.

The Fed cut interest rates in 11/02 and 6/03.

Unemployment finally appears to beresponding: 5.6% for the first half of 2004.


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What is the Feds policy instrument?

What the newspaper says:the Fed lowered interest rates by one-half point today

What actually happened:The Fed conducted expansionary monetary policy to

shift the LM curve to the right until the interest rate fell0.5 points.

The Fedtargetsthe Federal Funds rate:

it announces a target value,and uses monetary policy to shift the LM curve

as needed to attain its target rate.


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What is the Feds policy instrument?

Why does the Fed target interest ratesinstead of the money supply?

1) They are easier to measure than themoney supply

2) The Fed might believe that LMshocks aremore prevalent than ISshocks. If so, thentargeting the interest rate stabilizes incomebetter than targeting the money supply.(See Problem 7 on p.306)


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IS-LM and Aggregate Demand

So far, weve been using the IS-LMmodelto analyze the short run, when the pricelevel is assumed fixed.

However, a change inP

would shift theLMcurve and therefore affect Y.

The aggregate demand curve(introduced in chap. 9) captures thisrelationship between P and Y


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Y1Y2

Deriving the ADcurve

Y

r

Y

P

IS

LM(P1)

LM(P2)

AD

P1

P2

Y2 Y1

r2

r1

Intuition for slope

ofADcurve:

P (M/P)

LM shifts left

r

I

Y


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Monetary policy and the ADcurve

Y

P

IS

LM(M2/P1)

LM(M1/P

1)

AD1

P1

Y1

Y1

Y2

Y2

r1

r2

The Fed can increaseaggregate demand:

M LM shifts right

AD2

Y

r

r

I

Y at each

value ofP


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Y2

Y2

r2

Y1

Y1

r1

Fiscal policy and the ADcurve

Y

r

Y

P

IS1

LM

AD1

P1

Expansionary fiscal policy(G and/or T)

increases agg. demand:

T

C

IS shifts right

Y at each

value

ofP AD2

IS2


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IS-LMand AD-ASin the short run & long run

Recall from Chapter 9: The force that movesthe economy from the short run to the long run

is the gradual adjustment of prices.

Y Y

Y Y

Y Y

rise

fall

remain constant

In the short-runequilibrium, if

then over time,the price level will


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The SR and LR effects of an ISshock

A negative ISshock

shifts ISandAD left,causing Y to fall.

Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1)

IS2

AD2AD1


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Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1)

IS2

AD2AD1

In the new short-runequilibrium, Y Y


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Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1)

IS2

AD2AD1

In the new short-runequilibrium, Y Y

Over time,P gradually falls,which causes

SRAS to move down

M/P to increase,which causes LMto move down


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AD2


Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1)

IS2

AD1

Over time,P gradually falls,which causes

SRAS to move down

M/P to increase,which causes LMto move down

SRAS2P2

LM(P2)


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AD2

SRAS2P2

LM(P2)


Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1

)

IS2

AD1

This process continuesuntil economy reachesa long-run equilibrium

with Y Y


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EXERCISE:Analyze SR & LR effects of M

a. Draw the IS-LMandAD-AS

diagrams as shown here.

b. Suppose Fed increases M.Show the short-run effectson your graphs.

c. Show what happens in thetransition from the shortrun to the long run.

d. How do the new long-run

equilibrium values of theendogenous variablescompare to their initialvalues?

Y

r

Y

P LRAS

Y

LRAS

Y

IS

SRAS1P1

LM(M1

/P1

)

AD1


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The Great Depression

120

140

160

180

200

220

240

1929 1931 1933 1935 1937 1939

billionso

f1958

dollars

0

5

10

15

20

25

30

percentofla

borforce

Unemployment(right scale)

Real GNP

(left scale)

Th S di H th i


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The Spending Hypothesis:Shocks to the IS Curve

asserts that the Depression was largely dueto an exogenous fall in the demand for

goods & services -- a leftward shift of the IS

curve

evidence:

output and interest rates both fell, which is

what a leftward ISshift would cause

Th S di H th i


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The Spending Hypothesis:Reasons for the IS shift

1. Stock market crash exogenous C

Oct-Dec 1929: S&P 500 fell 17%

Oct 1929-Dec 1933: S&P 500 fell 71%

2. Drop in investment

correction after overbuilding in the 1920s widespread bank failures made it harder to

obtain financing for investment

3. Contractionary fiscal policy in the face of falling tax revenues and

increasing deficits, politicians raised tax ratesand cut spending

Th M H th i


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The Money Hypothesis:A Shock to the LM Curve

asserts that the Depression was largely due

to huge fall in the money supply

evidence:

M1 fell 25% during 1929-33.

But, two problems with this hypothesis:

1. P fell even more, so M/Pactually rose

slightly during 1929-31.

2. nominal interest rates fell, which is theopposite of what would result from a

leftward LMshift.

Th M H th i A i


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The Money Hypothesis Again:The Effects of Falling Prices

asserts that the severity of the Depressionwas due to a huge deflation:

P fell 25% during 1929-33.

This deflation was probably caused bythe fall in M, so perhaps money played

an important role after all.

In what ways does a deflation affect theeconomy?

Th M H th i A i


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The stabilizing effects of deflation: P(M/P) LM shifts right Y

Pigou effect:

P (M/P)

consumers wealth

C

IS shifts right

Y

Th M H th i Ag i


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The destabilizing effects of unexpected deflation:

debt-deflation theory

P(if unexpected)

transfers purchasing power from borrowers

to lenders

borrowers spend less,

lenders spend more

if borrowers propensity to spend is largerthan lenders, then aggregate spending falls,

the IScurve shifts left, and Y falls

The Money Hypothesis Again


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The destabilizing effects of expected deflation:e

r for each value ofi

I

becauseI

=I

(r)

planned expenditure & agg. demand

income & output


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Why another Depression is unlikely

Policymakers (or their advisors) now knowmuch more about macroeconomics:

The Fed knows better than to let M fallso much, especially during a contraction.

Fiscal policymakers know better than to raisetaxes or cut spending during a contraction.

Federal deposit insurance makes widespread

bank failures very unlikely.Automatic stabilizers make fiscal policy

expansionary during an economic downturn.


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Chapter summary

1. IS-LMmodel

a theory of aggregate demand

exogenous: M, G, T,

P exogenous in short run, Y in long run

endogenous: r,

Y endogenous in short run, P in long run

IScurve: goods market equilibrium

LM curve: money market equilibrium


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Chapter summary

2.AD curve

shows relation between Pand the IS-LM

models equilibrium Y.

negative slope because

P (M/P) rIY

expansionary fiscal policy shifts IScurve right,

raises income, and shiftsADcurve right

expansionary monetary policy shifts LMcurveright, raises income, and shiftsADcurve right

ISor LMshocks shift theADcurve

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Chap11(Agg Demand II)

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